Note Dec. 14, 2023: Markets Dance – To What Tune Sometimes with mirth, excess euphoria is attributed to retail investors but it is not the entire story. This aspect needs consideration at year end 2023. Whether bespoke or mechanical or in this age of high frequency activity and basically using similar variables, institutions can be pressured into window dressing, It is especially so when as in 2023 overall, equity leadership has been narrow and rigorous credit assessment been scarce in fixed income. While October 1987 was extreme, it was instructive that a wholesale swing in institutional positioning begets elevated volatility.
Capital markets appear to have already danced to at least three tunes. Into the end of 2023 and despite central bank reticence, capital markets appear reverted to earlier momentum mojos expecting early administered rate cuts supposedly with inflation imminently lower still. The breadth of this consensus seems massive. Currency markets appear sedate. Despite having lower than U.S. rates, the Canadian and Australian dollars seem stabilized. In Europe, spreads seem narrowed between benchmark German bunds versus conservative Dutch and weaker Italian fixed income. Both junk corporate and emerging country also appear to have participated in rallies. In an immense move, Japanese 10 year JGBs yields have been dropping. The credit crisis into 2008 illustrated the risks of ignoring elevated leverage and systemic risk.
The Federal Reserve in its FOMC statement of December 13, 2023 did link maintaining Fed Funds at 5 ½% with also keeping policy options open. Ranged from the Bank of Canada and Reserve Bank of Australia earlier as well as the Bank of England and the ECB now concurrently have kept rates in the 4 ½-5 ½% band. None can afford a currency stress of premature ease.
Stiff central bank resolve as currently and widely signaled as well as more fragile politics, trade and political economy strictures appear underappreciated. Given the current consensus within capital markets, major volatility impact would ensue from even small changes expectations from currency to fixed income to equities.
Any one of several political sparks could set off adversity for the present complacent capital market consensus. Global economic growth is weak and fractious. Despite bilateral summits such as of China and the United States and multilateral ones, from key minerals to information technology, managed trade and strategic stretch for protection of supply tensions appear ongoing. The south China seas have expanded physical tensions just short of war. Actual war continues from the Caucuses to the eastern borders of Europe to now North Africa and straddle key transport and hydrocarbon sources of energy. Despite COP28, security of expanding alternate energy supply appears at best a work in progress.
Aspects of inconsistencies and momentum appear in equities. The late rally in 2023 has been replete with S&P 500 valuation benchmark to 20+ P/E and for 30+ P/E for the narrow coterie leadership within Information Technology. On both risk premium and earnings delivery capabilities, equity valuations appear extended on lower interest rate expectations. Diversification may be in order, both within and between growth and value, with Financials crucial and Information Technology capped for potential risk on valuation and delivery dispersion reasons.
Sometimes accompanied by mirth, it may be convenient to assign excess euphoria to retail investors but it is not the entire story. This aspect needs consideration especially now, at year end 2023. Whether bespoke or mechanical or in this age of high frequency activity and basically using similar variables for input, institutions can be pressured into window dressing. It is especially a consideration when as in 2023 overall, equity leadership has been narrow and accompanied by elevated valuation. in fixed income appears a surfeit of momentum and stretching for yield even if attained by leveraged positioning. Rigorous credit stress assessment appears scarce. While October 1987 was extreme, it was instructive that a wholesale swing in institutional positioning begets elevated volatility. The credit crisis into 2008 illustrated the risks of ignoring elevated leverage and systemic risk when confronted by underappreciated weaknesses.
Over 2023, capital markets appear to have danced to at least three tunes. First came optimism in consensus for both sharp corporate earnings recovery and for significant central bank ease. While skimming over credit analysis, consensus appeared to be pining for basically a replay of central bank put(s) that would alleviate fiscal and balance sheet stress. After other global banking stress indications, then in the Spring of 2023 came major debacles in banking in Europe and the U.S. which exposed weaknesses both needing near term rescue and a requirement to address longer term stability. Instructively, central banks remained steadfast about long term requirements to rein in inflation and, led by the Federal Reserve, continued to raise administered rates. Within sovereign and within corporate fixed income markets, spreads expanded. Further and equally instructive, so did currency volatility even amongst OECD and G-7 countries. In equities, there appeared renewed interest in diversification while consensus equity earnings expectations diminished into minimal growth for 2023 and valuations dropped.
More recently into the end of 2023, we assess capital markets as having reverted to their momentum mojos which have characterized them overall subsequent to the exposure of the credit crisis in 2008. In effect, central bank put assumptions appear, this time to be in contrast to current positioning. The expectations come in the form of early administered rate cuts, supposedly on the basis of inflation having peaked. The breadth of this assumption by consensus seems massive, Currency markets seem again sedate. Despite having lower than U.S. rates, the Canadian and Australian dollars have stabilized upward. In Europe, spreads have diminished between German bunds and Dutch fixed income as higher credit as well as between them and Italian government 10 year maturities. Both junk corporate and emerging country also appear to have participated in rallies. In a salient move, Japanese 10 year JGBs yields have been dropping from close to 1% and down to close to 0.7%.
The Federal Reserve in its FOMC statement of December 13, 2023 did link maintaining Fed Funds at 5 ½% with also keeping policy options open. Ranged from the Bank of Canada and Reserve Bank of Australia earlier as well as the Bank of England and the ECB concurrently have kept rates in the 4 ½-5 ½% band. None can afford a currency stress of premature ease. A widespread policy positioning among central banks, emerging and advanced, is that inflation expectations need to be curbed for the long term. As benchmark, we see U.S. Fed Funds to still have a potential increase to 5 ¾% if required at June 2024 well ahead of elections in November and then another potential hike to a 6% level to be maintained for twelve months in order to get inflation to 2% targets of stability in 2025/6.
We expect that given the current consensus within capital markets, major volatility impact would ensue from even small changes in consensus expectations from currency to fixed income to equities. Stiff central bank resolve as currently and widely signaled as well as more fragile politics, trade and political economy strictures appear underappreciated by consensus.
Any one of several political sparks could set off adversity for the present complacent capital market consensus. The GATT and WTO pathways encouraged trade expansions into 2005. Currently, from key minerals to information technology, managed trade and strategic stretch for protection of supply tensions appear ongoing. Just within the G-7, Canada and Germany have weak economic coalitions or quasi such. A fractious election appears for November 2024 in both Congressional and U.S. Presidential politics. Much more than usual, disharmony appears at every step in the European Union. With the exception of India, growth in the emerging countries appears to be laggard, especially in China. Tensions have not been alleviated in the recent summits between China and the United States and then separately with the European Union. The south China seas have seen expanded physical tensions just short of actual war. Actual war continues from the Caucuses to the eastern borders of Europe to now North Africa These wars straddle key transport and global hydrocarbon sources of energy. The COP28 climate conference and security of expanding alternate energy supply appears at best a work in progress.
Aspects of inconsistencies and momentum appear in equities. On both risk premium and earnings delivery capabilities, equity valuations appear extended on lower interest rate expectations.Repeating in late 2023 in equities has been the modus operandi since 2008 of favoring momentum, globally and in the S&P 500 as benchmark. Oft reduced consensus for earnings has been rewarded. Compared to our 5-10% expectation for 2024, the latest consensus iteration for S&P 500 earnings has no earnings growth for 2023 but 15-20 % growth pushed again into the out year of 2024. The late rally in 2023 has been replete with S&P 500 valuation benchmark to 20+ P/E and for 30+ P/E for the narrow coterie leadership within Information Technology. We assess that both are likely to be difficult to deliver over full cycles. Buttressing by central bank ease would seem to be at odds with strong earnings recovery.
Diversification may be in order, within and between growth and value. Delivery among Financials is crucial. Information Technology we have capped for potential risk on valuation and delivery dispersion reasons. Diversification within growth likely has two elements. On business prospects and development, Information Technology has long had both Darwinian and cooperative sides. Currently on artificial intelligence, product and services supply for 5G and upcoming 6G it is unlikely for benefits to be limited to a tiny coterie of high valuation companies. For this coterie as well, valuation spreads seem massive when compared to Healthcare and Consumer Staples.
In value and cyclicals, slow growth and debt workout looms for a more frugal Chinese consumer. For income distribution reasons, especially the U.S. but also other advanced country consumers may also be entering a post-holiday frugal phase. Increased defense spending, infrastructure efficiency and strategic availability potential all offer opportunity in the Industrials and Materials.
Seasons Greetings E.o.e.